Tuesday, January 02, 2007

This is the latest report on the 4th quarter economic results from TD Canada Trust

HIGHLIGHTS

Data confirm Canadian economic slowdown in Q4U.S. PPI and housing starts bounce up, but not a trendInvesting themes for 2007There was no holiday cheer in this week's Canadian economic releases. The Scrooge-like data revealed that the economy ground to a halt as it entered the fourth quarter of 2006. After contracting by 0.4% in September (revised from -0.3%), the economy disappointed expectations for a rebound and posted absolutely no growth in October.

Canadian economy struggles in Q4

From a sectoral point the news was as depressing as visits from the ghosts of the past, present and future. Manufacturing output contracted 0.8% in October, marking a ninth monthly decline for the year. This dismal out-turn was far from surprising and there is little hope for a Christmas miracle that will turn things around any time soon. For an in-depth discussion of the challenges facing manufacturers please refer to the report released this week entitled "Pressure Makes Diamonds: A Road Map for Canadian Manufacturing".

Looking beyond the beleaguered manufacturing sector, there were signs of weakness in several other areas. Transportation and warehousing also posted a significant decline in October, but this is likely tied to the suffering in manufacturing and reflects the impact of a slowing U.S. economy on Canadian exports.

More eye-opening was news of slower growth in some service sectors. Wholesale trade edged down 0.2% in October, marking the first back-to-back monthly decline in two years. The story was the same in retail, where sales fell 0.7% in October, building on a 1.2% decline in September. Worse still, the weakness in retail shifted from being largely an auto story to being broadly based, with ex-auto sales down 0.7% in October. And, these results were not caused by price effects. The volume of wholesale trade dropped 0.8%, while retail contracted 0.5%.

This puts the Canadian economy on a particularly soft footing in the fourth quarter. For example, if the economy posted a 0.3% rebound in November and 0.2% advance in December, both of which are well within the realm of possibility, real GDP at basic prices in the fourth quarter would come in at 0.3% annualized. While Governor Dodge has gone on record as saying that economic growth will likely disappoint the Bank of Canada's forecast of 2.8%, it is unlikely that the central bank was anticipating the possibility of virtually no growth in the final three months of the year. To be fair, we would also be extremely disappointed, since our projection was for a gain of 1.8%.

Having said all of that, there is a very good chance that economic growth will come in higher than the monthly data are suggesting. The monthly real GDP at basic prices is not always a good predictor of what the quarterly national accounts show in terms of real GDP on an income and expenditure basis, because the latter factors more directly trade flows and inventory fluctuations. There is also a good chance that economic growth will surprise on the upside in November and December. We think the weakness in retail activity is a bit odd, particularly given the strong fundamentals of low unemployment, rising real personal income, modest interest rates and high consumer confidence, which should make for robust consumer spending. For a complete explanation of the economic outlook see The Quarterly Economic Forecast released on December 19th.

So, the main message is that the data confirm that the Canadian economy has definitely shifted down a gear and economic growth could fall well short of our initial 1.8% projection in the fourth quarter. However, this out-turn only adds to our view that the current economic slowdown will force the Bank of Canada's hand and lead to rate cuts in the spring. It is also consistent with our view that the Canadian dollar will remain range bound near current levels, as deteriorating domestic economic conditions and expectations for rate cuts will limit the ability of the loonie to benefit from weakness in the U.S. dollar.

Mixed U.S. data don't alter assessment of slowdown

The U.S. data painted a very mixed picture this week. Markets received a shock when it was reported that the Producer Price Index shot up 2.0% in November and housing starts surprised on the upside with an increase to 1588 thousand units. The knee jerk reaction from many pundits was that inflation remained a risk and the worst is behind U.S. real estate.

We don't subscribe to either of these views. First, there is a very weak relationship between producer and consumer prices. This was confirmed on Friday with the report that the core Personal Consumption Expenditure (PCE) deflator - the U.S. Federal Reserve's preferred measure of inflation - was unchanged in November and the year-over-year rate fell two-tenths of a point to 2.2%. Second, we still believe that there is one to two more quarters of weakness to come in real estate.

And, while the consumer is hanging in much better than we anticipated, with personal expenditure rising 0.5% in November, we continue to believe that the housing correction will act with a lag, dampening spending in the new year. Moreover, the recent strength on the consumer front is being offset by softer business investment. Although a 1.9% increase in overall durable goods orders in November looked good, the more important core capital goods orders that are a leading indicator of business investment contracted 1.4%.

Investing themes for 2007

The bottom line is that the U.S. and Canadian economies are in the midst of an economic slowdown, with the pace of expansion running well below their long-term potential rates of 3.3% and 2.8%, respectively. As this continues over the next two to three quarters, the resulting accumulation of economic slack will diminish the price pressures present and cause financial markets to anticipate central bank rate cuts, which we believe will arrive in the spring. However, this is unlikely to lead to a significant rally in the bond market, which has already priced in much of the forthcoming weakness. It is also not expected to spark a major correction in commodity prices, although crude oil and base metals could give up some of their gains in the near-term. Equity markets in both the U.S. and Canada may face headwinds from slowing profit growth, but they will be forward looking and should anticipate strong economic conditions, particularly when the central banks start telegraphing rate cuts. And, with those investing themes for 2007, TD Economics wishes readers all the best for the holidays and in the New Year.

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